What’s going on with the gold price?
In US dollars (the most important global benchmark), it’s trading just over US$1,200 an ounce, after being well above US$1,300 an ounce earlier in the year.
The yellow metal just can’t seem to take a trick. In recent months, as stress in some currency markets increased, the gold price dropped sharply, to an intra-day low of around US$1,160 an ounce. You can see this plunge in the chart below:
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The issue for gold is the strength of the US dollar. When the US dollar is strong, gold (expressed in terms of US dollars) usually falls. Gold is an anti-US dollar trade.
The US dollar has been rising for a number of reasons.
The US economy is the strongest developed economy in the world right now. As a result, official interest rates are on the rise. This makes US dollar denominated assets attractive relative to other international assets.
But don’t write gold off just yet. There are a number of things occurring beneath the surface that could prove very bullish for gold in the months to come, and into 2019.
Firstly, let’s look at the currency issues going on in some emerging markets. For example, Turkey and Argentina have suffered massive capital outflows this year. As a result, their currencies fell to an all-time low against the US dollar.
In a recent update to subscribers of my investment advisory, Crisis & Opportunity, I hypothesised that perhaps the Bank for International Settlements (BIS) was behind the gold price weakness.
How is the BIS behind the weak gold price?
Well, the BIS controls massive amounts of gold. In order to stabilise plunging currencies and satisfy a large, short term increase in demand for US dollars, I surmised that the BIS may have entered into a significant number of gold swaps on behalf of these beleaguered currencies.
That is, it ‘swapped’ gold (in the form of a short-term contract) for US dollars to ease tensions in the currency markets. This has a short-term negative effect on gold, as it represents a sell gold/buy US dollars trade. But it must be unwound in the future, which is likely to represent a buy gold/sell US dollars trade.
This also possibly explains why futures traders are ‘short’ with a record amount of gold contracts right now. When traders eventually unwind those positions, it will likely represent a huge amount of buying power and could push gold sharply higher.
Then there is the US dollar angle, which is highly complex.
We all know the US economy is strong right now. And much of it has to do with the Trump tax cuts, which came into effect early this year.
To finance those cuts, the US had to borrow. This fiscal year (which ends this month in the US), the US will run a Federal deficit of nearly US$900 billion. For the following three fiscal years after that, the budget deficit is projected to be over US$1 trillion.
A lot of debt needs to be issued to finance this gaping hole in the budget. Worryingly, these deficits will occur at a time when the economy is at, or close to a cyclical high. What’s going to happen when the economy slows and tax receipts drop off?
So the Treasury Department is flooding the global market with bonds to finance the deficit. At the same time, the US Federal Reserve is reducing its balance sheet in a process known as ‘quantitative tightening’ (QT).
You may remember that in the aftermath of the credit crisis of 2008, the Fed bought up huge amounts of Treasury bonds and mortgage-backed securities. It did this to provide liquidity to the system and satisfy the huge demand for cash. Over the years, the Fed’s balance sheet swelled to US$4.5 trillion.
But now it’s reversing that process. The Fed currently sells US$30 billion of bonds back into the market each month, and may increase that to US$50 billion per month in the fourth quarter.
What will be the combined effect of all this?
Well, we do know that when the Fed removes bonds off its balance sheet, it takes ‘cash’ (Federal funds) out of the system. They are effectively selling the bonds back to the market. Less cash in the system means less liquidity.
To the extent that there is less demand for cash (due to greater appetite for risk assets) this is not a problem. It will be in the future, but it’s not now.
This simultaneous reduction of liquidity and issuing of massive amounts of additional treasury bonds to finance the deficit is all US dollar positive in the short term.
Think of the foreign investor who wants out of emerging market debt and wants to buy US treasuries instead. It’s a sell ‘other currency’ and buy US dollars trade. But once the treasuries are in circulation, the heightened demand for the US dollar must remain. It’s like a new equilibrium level.
The question is, how long will the demand for US dollars remain at elevated levels? I don’t know, but it’s an important question for gold investors to think about.
From the chart above, you can see that the gold price is in a downtrend. But there is a chance that the sharp low in August might be THE low.
What you want to see here is gold start to move sharply higher. A close above US$1,215 an ounce will be a good start. If that happens, it’s the market saying that the gold/US dollar dynamic is starting to change in favour of gold.
Tomorrow, I’ll look at the political reasons why this might be happening…
Editor, Crisis & Opportunity
PS: If you’re thinking now is the time to jump back into gold investments…you could be making a huge financial blunder! Find out why here.